Read this article to learn about the advance method and techniques of inventory control: ABC analysis, EOQ model, safety stocks and the reorder point!
Inventories occupy the most prominent position in the working capital structure of manufacturing and distributive business enterprises.
For example, on an average inventories are approximately 60 per cent of the current assets in public limited companies in India.
Inventory Control is a science- based art of ensuring that sufficient inventory is held by an organization to meet both its internal and external demand commitments economically. Gopalan and Sandhilya are of the opinion that uncontrolled inventory can become an organization’s cancer. ”Managing the level of investment in inventory is like maintaining the level of water in a bathtub with an open drain. The water is flowing out continuously. If water is let in too slowly, the tub is soon empty. If water is let in too fast, the tub overflows. Like the water in the tub, the particular items in inventory keep changing, but the level may stay the same. The basic financial problems are to determine the proper level of investment in inventory and to decide how much inventory must be acquired during each period to maintain the level.”
In fact, stock management is essentially the production manager’s concern. The finance manager’s interest is simply that the stock balance which results is an investment that needs financing. Thus, the finance manager should expect to be handed an optimal stock figure by the production manager.
The financial manager is a kind of watch-dog over other functional areas in conformity with the goal of wealth and profit maximization. The top level management should, therefore, keep a bird’s eye view over inventory with the principle of “neither too much nor too little” by cost-benefit analysis.
The momentous decisions faced by management are how much to order when to order, what safety stocks to keep, and what stock-out probabilities and levels are acceptable. The major production oriented methods and techniques of inventory control for managing inventories efficiently are: the ABC analysis, the EOQ model, safety stocks, and the re-order point.
Methods and Techniques of Inventory Control
1. ABC analysis:
The basic work in this always better control analysis is the classification and identification of different types of inventories, for determining the degree of control required for each. In many firms it is found that they have stocks which are used at very different rates. So items are classified under three broad categories A, B and C, on the basis of usage, bulk, value, size, durability, utility, availability, criticality etc.; and should be controlled with due weightage to differential characteristics.
The items included in group A involve largest investments and the inventory control should be most severe to these items. C group consists of inventory items which involve relatively small investments although the number of items remains large. These items deserve minimum attention of control. In B group that items are included which are neither of A nor C. This method can be explained by the following exhibit.
Classification of Inventory Items:
|Class||No. of Items (per cent of total)||Value of Items (per cent of total)|
From the figure it can be observed that there are comparatively few items in A but they constitute a large proportion of the total rupee value; B items are in the intermediate range and C items are numerous but inexpensive.
The purpose behind the ‘distribution by value’ analysis is ‘Always Better Control’. Donald G. Hall recommends that different attitudes shall be adopted in inventory management—aggressive for class A items, active for class B items and loose for class C items; and that each category should be given the attention as deserves. R.S. Chadda recommends the following order for selective control:
|A Items||B Items||C Items|
|6. Safety Stocks||Low||Medium||Large|
(Adapted from P.V. Kulkarni, Financial Management—A Conceptual Approach).
2. Economic order quantity model:
The basic decision in an economic order quantity (EOQ) procedure is to determine the amount of stock to be ordered, at a particular time so that the total of ordering and carrying costs may be reduced to a minimum point. A firm should place optimum orders and neither too large nor to small. The EOQ is the level of inventory order that minimizes the total cost associated with inventory. The EOQ model is based on following four assumptions:
(i) A firm has a steady and known demand of D units each period for a particular input.
(ii) The firm consumes the input at a uniform rate.
(iii) The costs of carrying stocks are a constant amount C per unit per period.
(iv) The costs of ordering more inputs are a fixed amount O per order. Orders are delivered instantly.
A useful formula for calculating the optimum order quantity is:
EOQ = √2DO/ C
To show how we might use the formula consider exhibit III in which a firm has an annual inventory requirement of 10,000 units. The accounting costs associated with placing an order with the supplier come to Rs. 200 per order and the carrying costs of holding stocks are expected to be Rs. 4 per unit.
Hence, D=10,000 units
EOQ = √2 x 10,000 x 200/ 4
= 1,000 units
Therefore, 1000 units should be ordered every 37 days.
The EOQ model is very simple one and its assumptions will be unrealistic in many applications, in practice orders are not delivered instantly. The assumption of a constant usage of inventory and known annual demand are of doubtful validity.
3. Minimum Safety Stocks:
To avoid stock-outs firms maintain safety stocks of inventory. The safety stock is the minimum level of inventory desired for an item given the expected usage rate and the expected time to receive an order. If an order is placed when the inventory reaches 12,000 units instead of 10,000 units, the additional 2,000 units constitute a safety stock.
The manager expects to have 2,000 units in stock when the new order arrives at the scheduled time. The safety stock protects as a safe-guard against stock-outs ‘position due to unanticipated increase in usage resulting from an unusually high demand and/or an uncontrollable late delivery of inventories.
The increase in the amount of inventory held as safety stock reduces the chances of stock-out and therefore, reduces stock-out costs over the long-run. The level of inventory investment is, however increased by the amount of safety stock. The optimum level of safety stock is determined by the trade-off between the stock-out and the carrying costs.
Thus the best level of safety stock for a given item depends on stock-out costs, variability of usage rates and delivery times. The safety stock level is the multiplication of the average demand during a period of the maximum delay and the probability of its occurrence.
If the usage rate and delivery time or lead time can be forecasted with a high degree of accuracy and if the cost of stock-out is estimated to be small, then little or no safety stock will needed. If the circumstances are not so favourable, then the significant investment in safety stock will be desirable.
4. Re-order point:
In addition to set EOQ, the inventory management must know when to place the order for avoiding the stock-out position. Especially in the Indian context where there is a considerable time lag between placing the order and actual receipt of the inventory, determining the re-order point (ROP) is momentous as well as intricate. The ROP may be defined as that level of inventory at which a fresh order should be placed to the suppliers for replenishing the current stock.
The ROP is calculated as the lead time X daily usage. The lead time is the time lag between raising an order and the goods being delivered. For example, if the normal daily usage of materials is 100 units and it takes 30 days for the supplier to deliver the goods, then an order must be sent out when the stock level reaches 3,000 units. If safety stocks are held then re-order level should be: safety stock+ (lead time x daily usage).
Another method of ordering is the ‘two bin’ and ‘three bin systems. These involve putting a quantity equal to the re-order level in a separate bag or bin which is sealed or put in a separate location; the rest of the stock is withdrawn as needed with no record of individual usage being kept.
Opening the sealed bin, however, gives the indication for a replenishment order. This method is cheap as it does not entail continuous, monitoring and is easy to understand—it has therefore gained a fair amount of acceptance. There are also other types of system in use known as ‘the ‘min-max’ or ‘S-s’ ‘method. However, an organization will have to take care of the lead time with sufficient initial stock and then follow it up regularly with EOQ cycles.